Haunted by a Spectre
Paul Krugman, The Return of Depression Economics and the Crisis of 2008 (Norton, 2009).
My only literary prediction for 2009 is that we’re all going to be reading a lot more books about what was formerly known as The Economy, and is currently variously called The Crisis, The Collapse, Things Are Going to Get Worse Before They Get Better, The Brink of Great Depression II, and “A Spectre Is Haunting…” The spectre is haunting not just Europe, as the opening line of Marx and Engels’ Communist Manifesto of 1848 had it, but the entire globe, though it’s unlikely that it’s the “spectre of Communism” that’s doing the haunting, as the mid-19th century revolutionaries claimed. What to call the spectre will no doubt be the subject of many of this year’s forthcoming books.
Personally, I’m looking forward to the book that tells-all about the aptly-named Bernie Madoff, the New York financial wizard who allegedly made off with $50 billion in investors’ money in the biggest Ponzi scheme in history. (According to a book blog I recently glanced at, there are 8 such accounts in the works.) Or the inside story of that night in September 2008 when then President George W. Bush, the enemy of big government and lifelong proponent of unregulated cowboy capitalism, was told by Treasury Secretary Hank Paulson and Federal Reserve chair Ben Bernanke that the U.S. would have to, more or less, nationalize the entire finance and banking sector… or else. What did Dubya mutter, I wonder? “Gadzooks, that’s socialism! What will my daddy say?” We won’t know until the next Bob Woodward inside-the-White-House tome appears, I guess, but in any case it promises to be more exciting than Dan Brown’s sequel to The DaVinci Code.
While awaiting these nasty-pieces-of-work-in-progress, we already have available a range of tempting titles that includes Canadian economist Jim Stanford’s indispensable primer, Economics for Everyone: A Short Guide to the Economics of Capitalism (Fernwood, 2008), and the British-born Harvard historian Niall Ferguson’s latest TV-series-text, The Ascent of Money: A Financial History of the World (Penguin, 2008). For those still catching up with the last century, there’s Robert Skidelsky’s suddenly relevant massive biography, John Maynard Keynes (1883-1946): Economist, Philosopher, Statesman (Pan, 2003).
My own favourite Virgil-like guide to our present economic Hell is Paul Krugman, winner of the 2008 Nobel Prize for Economics. He’s also a Princeton professor, a New York Times columnist, and a self-declared liberal economist, author of The Conscience of a Liberal. It was Krugman who asked in a recent column (“The Madoff Economy,” New York Times, Dec. 19, 2008), “How different, really, is Mr. Madoff’s tale from the story of the investment industry as a whole?” But before contemplating the possibility that much of capitalism is itself a Ponzi swindle writ large, we need a little background.
That’s provided by Krugman in his slim and cautionary new book, The Return of Depression Economics. Actually, as Krugman explains in his introductory chapter, Depression Economics is a recycled version of his not-much-noticed 1999 text about the bursting of the Asian monetary bubble and other warning signs ignored, hence the add-on subtitle, …and the Crisis of 2008, for this year’s edition. It’s a literary example of “doing more with less,” a conception that millions of us will probably have to adopt in the coming months.
As recently as the beginning of the 21st century, as Krugman reminds us, it was believed that “nothing like the Great Depression can ever happen again.” The monumental slump of the 1930s was now seen by economists and other policy makers as a “gratuitous, unnecessary tragedy.” If only the U.S. president of the day, Herbert Hoover, “hadn’t tried to balance the budget in the face of an enormous economic slump”; if only “officials had rushed cash to threatened banks, and thus calmed the bank panic”; if only… But in today’s enlightened era, claimed many prominent economists, we know better. Or do we?
Krugman sets up his account of the present crisis by reviewing various economic disasters and near-disasters of the past two decades in Mexico, Japan, Thailand and other points east and south, as well as doing the forensics on recent American economic “bubbles” that eventually burst. He also explains some of the machinations of the stock market and other frightening institutions. Occasionally my eyes glazed over as Krugman explained how fortunes were made by turning Thai bahts and Mexican pesos into other currencies, but for the most part, the analysis is pretty accessible, thanks to his commitment to ensuring that “there are no equations, no inscrutable diagrams, and (I hope) no impenetrable jargon” in his little treatise.
In due course, Krugman gets to the irrational housing bubble that initiated the present crisis. “Americans have long been in the habit of buying houses with borrowed money,” Krugman notes, then adds, “but it’s hard to see why anyone should have believed, circa 2003, that the basic principles of such borrowing had been repealed. From long experience we knew that home buyers shouldn’t take on mortgages whose payments they couldn’t afford, and they should put enough money down so that they can sustain a moderate drop in home prices and still have positive equity.”
Instead, “what actually happened was a complete abandonment of traditional principles.” A small part of the blame can be pinned on “the irrational exuberance of individual families who saw house prices rising ever higher and decided that they should jump into the market, and not worry about how to make payments.”
But the real culprits, says Krugman, were the lenders. “Buyers were given loans requiring little or no down payment, and with monthly bills that were well beyond their ability to afford — or, at least would be unaffordable once the initial low, teaser rate reset. Much though not all of this dubious lending went under the heading of ‘subprime,’ but the phenomenon was much broader than that,” and the total amount of the loans was in the hundreds of billions.
Why did the lenders relax the traditional standards, and why were they allowed to do so? Well, first, they too bought into the psychological bubble of believing in ever-rising house prices. They didn’t have to worry about whether the borrowers could make their monthly payments. If they couldn’t they could either get more cash by taking out a home equity loan or else sell the house, at a higher price, and pay off their mortage.
But far more important — and here’s where it gets interesting — the lenders didn’t worry about the loans “because they didn’t hold on to them. Instead, they sold them to investors, who didn’t understand what they were buying.” The process is known as “securitization” of home mortgages — “assembling large pools of mortgages, then selling investors shares in the payments received from borrowers.” Previous “securitization” had been limited to “prime” mortgages, that is, loans to borrowers who could make a substantial down payment and had enough income to meet the mortgage payments. Defaults were rare.
As the bubble inflated, everyone reached for a piece of pie-in-the-sky. Construction boomed, materials for construction were in demand (including wood from British Columbia), low unemployment and money in hand fuelled consumer purchases on big ticket items such as SUVs and newly-invented electronic gadgets (all aided and abetted by the availability of further borrowing via credit cards), and you could even call in for pizza. All boats were lifted in the rising tide of prosperity, including all those borrowed boats. Eventually, when the people who made the loans they couldn’t afford stopped paying, the foreclosures on houses began, housing prices plummeted, construction and consumption stopped, the boats whether bought or borrowed ran aground, and the bubble had burst. It was only when the plug was pulled that we learned that these weren’t real boats, but only children’s toys in a bathtub. The boats may not have been real, but people’s lives going down the fiscal drain surely were.
According to Krugman, the “financial innovation” that made this enormous conjuring trick possible was something called “collateralized debt obligation” (CDOs). The CDOs created “senior” shares that were supposedly secure, and junior shares that were more speculative. The CDOs were touted as a very safe investment because “even if some mortgages defaulted, how likely was it that enough would default to pose problems for the cash flow to these senior shares?” The answer: “Quite likely, it turned out.” But because of the hype, the supposed watchdog or rating agencies were willing to classify senior CDO shares as AAA, “even if the underlying mortgages were highly dubious.” Of course, “as long as housing prices kept rising, everything looked fine and the Ponzi scheme kept rolling.” Since the CDOs were rated safe, that “opened up large-scale funding of subprime lending” to such institutional investors as pension funds that “were quite willing to buy AAA-rated assets that yielded significantly higher returns” than ordinary bonds and other super-safe properties. But once the bubble burst, we got this, the present monstrous mess.
In order to make the scheme work, there had to be institutions to bundle together and peddle the ultimately worthless mortgages. At this point Krugman introduces us to the crucial concept of the “shadow banking system.” Krugman asks, “But wasn’t the age of banking crises supposed to have ended seventy years ago? Aren’t banks regulated, insured, guaranteed up the wazoo? Yes and no. Yes for traditional banks; no for a large part of the modern, de facto banking system.”
In his thumbnail history of banking, Krugman notes that something eerily similar to what’s going on today happened one hundred years ago in the Panic of 1907. “The crisis originated in institutions… known as ‘trusts,’ bank-like institutions” originally intended to manage inheritance and estates for the wealthy. “Because they were supposed to engage only in low-risk activities trusts were less regulated and had lower reserve requirements and lower cash reserves than national banks.” As the economy boomed in the first decade of the last century, “trusts began speculating in real estate and the stock market areas from which national banks were prohibited.” As long as the bubble inflated, “trusts were able to pay their depositors higher returns.” When the bubble burst, it took all the republic’s bankers to restore a semblance of fiscal order. Even though the actual panic lasted only a week, “it and the stock market collapse decimated the economy. A four-year recession ensued, with production falling 11 per cent” and unemployment almost tripling.
Krugman then describes the far larger crisis of 2008, one that has a global rather than a merely national reach, and along the way he discusses the various arcane instruments and institutions of investment from the “auction-rate security system” to “hedge funds” and all the rest of the shadowy shadow-banking system that ultimately caved in, beginning with the 2008 bankruptcy of Lehmann Brothers. Krugman notes that the unsustainable risk of such institutions wasn’t really a result of deregulation, but rather that the shadow system, which was almost as large as conventional banking, was never regulated in the first place, even though the top five investment banks had balance sheets totalling $4 trillion. The catastrophe is a result of what Krugman calls “malign neglect.” Nonetheless, what permitted much of the malign neglect was an ideology of unregulated market capitalism and almost-theological opposition to government.
My recurrent emotion while reading Krugman’s account (and I’ve only reprised a small portion of the complexities) was one of shock. Again and again, I found myself gasping with astonishment, “They let them do that?!” Much of the operation of the financial system looks like little more than a besotted weekend of casino gambling. Though I can hardly claim to be utterly naïve about the workings of capitalism, Krugman’s brief book repeatedly brings home how little most people (including me) really know about what’s going on. I guess that as long as our credit cards still work with a simple swipe through a machine perhaps we don’t want to know. But at this point, continued ignorance is not an option.
Krugman wraps up with the important “What is to be done?” question. His solution, which is pretty close to that of the ideas of President Barack Obama’s economics team, is straightforward, and not especially radical. “What the world needs right now is a rescue operation. The global credit system is in a state of paralysis and a global slump is building momentum,” Krugman declares. Reform “is essential, but it can wait a little while.” Right now, policy-makers around the world “need to do two things: get credit flowing again and prop up spending.”
Krugman guesses that “recapitalization” of the economy will come close to requiring “a full temporary nationalization of a significant part of the financial system.” Other leading economics experts have been openly discussing the same thing (see “Nationalizing the Bank Problem,” New York Times, Jan. 22, 2009). Apart from loony-tune right-wing Republicans and neo-conservative thinktanks (a “shout-out” to the fabled Fraser Institute is appropriate here), there’s a near-consensus that temporary nationalization is not unthinkable. Since the spectre haunting global capitalism isn’t a radical reorganization of economic life, Krugman underscores that he isn’t advocating the long-term seizure of the economy’s commanding heights, as the Marxists used to say, and insists that “finance should be reprivatized as soon as it’s safe to do so, just as Sweden put banking back in the private sector after its big bailout in the early 1990s.” He adds, however, “Nothing could be worse than failing to do what’s necessary out of fear that acting to save the financial system is somehow ‘socialist.'” Some of us might be tempted to further add, “So what’s wrong with a little socialism?”, but we can leave that debate for another occasion.
Even if the credit markets can be brought back to life, what to do about the gathering global depression? “The answer, almost surely,” says Krugman, “is good old Keynesian fiscal stimulus.” That is, the next plan “should focus on sustaining and expanding government spending — sustaining it by providing aid to state and local governments, expanding it with spending on roads, bridges and other forms of infrastructure.” That’s pretty much what Obama proposes in his most recent $800 billion stimulus package, including such other forms of “infrastructure” as education and green technology.
Krugman says, more than once, “We’re not in a depression now, and despite everything, I don’t think we’re heading into one,” then parenthetically adds, “although I’m not as sure of that as I’d like to be.” If depression itself has not returned, depression economics — meaning, “the kinds of problems that characterized much of the world economy in the 1930s” — is back with a vengeance. Krugman’s useful discussion is hardly deathless prose, nor is it meant to be. It’s more on the order of “dispatches from the front,” a front that’s not located in some distant land, but is as close as your local haunting spectre.
Vancouver, Jan. 22, 2009.